Updated on February 27th, 2019 by Josh Arnold
For superior long-term returns, investors should focus on high-quality dividend growth stocks. This comes to mind when reviewing the Dividend Aristocrats, a select group of 57 companies in the S&P 500 Index with at least 25 consecutive years of dividend increases.
We review all 57 Dividend Aristocrats each year, and the next stock in the series is beverage giant The Coca-Cola Company ( KO).
Coca-Cola has a dividend yield of 3.6%, which is nearly double the S&P 500 average yield of 1.9%. In addition, Coca-Cola is likely to continue raising its dividend each year.
This is a difficult time for Coca-Cola. Consumer preferences are changing, and soda consumption continues to wane in the U.S.
Because Coca-Cola’s earnings growth has slowed, the stock continues to appear overvalued. However, it remains a high-quality business with strong brands, and an attractive dividend yield.
In addition, it has been diversifying away from sparkling beverages in recent years and those efforts have paid off. Growth appears to be on the horizon, improving the outlook for the beverage giant.
This article will examine Coca-Cola’s investment prospects in detail. Before digging in, you may want to examine Coca-Cola’s long-term fundamentals, which are plotted below:
Coca-Cola was founded in 1892. Today, it is the world’s largest non-alcoholic beverage company. It owns or licenses more than 500 non-alcoholic beverages, including both sparkling and still beverages.
It now sells products in more than 200 countries around the world, and has 21 brands that each generate $1 billion or more in annual sales.
The sparkling beverage portfolio includes the flagship Coca-Cola brand, as well as other soda brands like Diet Coke, Sprite, Fanta, and more. The still beverage portfolio includes water, juices, and ready-to-drink teas, such as Dasani, Minute Maid, Vitamin Water, and Honest Tea.
Source: Investor Presentation
Coca-Cola dominates sparkling soft drinks, where it commands over 50% market share. The company is attempting to maintain and even improve this dominant position with product extensions of existing popular brands, including reduced and zero-sugar versions of brands like Sprite and Fanta.
This is a challenging time for Coca-Cola. Soda consumption in the U.S. has fallen for more than a decade. Declining soda consumption is a significant challenge for the company.
While Coca-Cola’s total volumes certainly still rely upon sparkling beverages such as soda, the company has gone to great lengths in recent years to diversify away from its core products, understanding that the long-term growth prospect for sparkling beverages isn’t particularly inspiring. Coca-Cola has acquired multiple still beverage brands in recent years.
Coca-Cola reported Q4 earnings on 2/14/19 and while results were fine, guidance for 2019 sent investors heading for the exits. Total revenue was off 6% during the quarter, but that was due to the company’s ever-present currency headwinds, as well as its bottler refranchising efforts.
Coca-Cola has seen its revenue decline for years as it continues to divest bottling operations, but on an organic basis, revenue rose strongly, up 5%. This was thanks to a 1% gain from concentrate sales and a 4% gain from pricing and mix; volume was flat in Q4. While flat volume isn’t ideal – and reflects continued challenges with the sparkling beverage portfolio – Q4’s organic revenue number was stronger than anticipated.
Operating income was up nicely as well, adding 21% in Q4 thanks to ongoing productivity efforts as well as higher margins from the bottling divestitures. Indeed, a primary reason the company is undertaking this effort is because the bottling business has very low margins and doesn’t fit the company’s long-term goals.
In total, fourth quarter earnings-per-share increased 9% on an adjusted basis and was negatively impacted by a 10% headwind from currency exchange. Coca-Cola’s enormous non-US presence means it is particularly susceptible to currency fluctuations, and Q4 saw a particularly large swing from this.
Guidance for 2019 was for organic revenue growth of 4%, but flat earnings-per-share. Management cited declining economic growth outlooks in certain parts of the world, continued currency swings, and rising transportation costs. As a result of this weak guidance, our initial estimate for 2019 earnings-per-share is $2.05, which is a fractional decline from 2018.
On 2/21/19, Coca-Cola authorized its 57th consecutive annual dividend increase, raising the payout from $1.56 to $1.60 per year.
In an effort to return to growth, Coca-Cola has invested heavily outside of soda, in areas like juices, teas, dairy, and water, to appeal to changing consumer preferences. Despite weak guidance from an earnings perspective in 2019, we continue to see Coca-Cola as having a favorable long-term growth outlook.
One reason we like the stock is because it competes in an industry that continues to grow globally in excess of the rate of broad economic growth. This leads to strong levels of overall growth in the industry, which Coca-Cola has certainly been capitalizing on in recent years.
In addition, the ready-to-drink category is sold through highly-diversified channels and continues to have mid-single digit projected growth rates, both for Coca-Cola and the industry. This is particularly true for still beverages like milk, tea and water. Coca-Cola’s years-old strategy to diversify away from sparkling beverages is due to this and it is undoubtedly bearing fruit.
Coca-Cola also continues to acquire brands in order to grow, including its unexpected acquisition of Costa, a coffee brand based in the UK.
Source: Investor Presentation
This is certainly an out-of-the-box buy for a sparkling beverage behemoth, but Coca-Cola is doing what it takes to secure its future.
Finally, we continue to like the nearly-complete plan to divest the company’s bottling operations. The major portions of the plan are complete and the rest should be done shortly.
This has resulted in some pretty significant revenue declines over the years, but the end goal is higher margins. That has already begun occurring and with completion of the transformation in 2019, revenue growth will return. Not only will revenue move higher, but margins will continue to do so as well.
Taking all of this into account, in addition to the company’s ample buyback program and productivity efforts, we see total earnings-per-share growth of 6% annually in the coming years. This year is one of transition thanks to the bottling divestitures, but Coca-Cola should see meaningful growth beginning in 2020.
The company’s dividend is now up to $1.60, a 2.6% increase from the prior payout. The current yield is 3.5%, which is higher than it has been for just about all of the past decade. On this measure, Coca-Cola seems quite attractive for income investors.
Competitive Advantages & Recession Performance
Coca-Cola enjoys two distinct competitive advantages, which are its strong brand and global scale. According to Forbes, Coca-Cola is the sixth-most valuable brand in the world. The Coca-Cola brand is worth $57 billion.
In addition, Coca-Cola has an unparalleled distribution network. It has the largest beverage distribution system in the world. Of the roughly 60 billion beverages consumed around the world every day, about 2 billion come from Coca-Cola.
These advantages allow Coca-Cola to remain highly profitable, even during recessions. The company held up very well during the Great Recession:
- 2007 earnings-per-share of $1.29
- 2008 earnings-per-share of $1.51 (17% increase)
- 2009 earnings-per-share of $1.47 (3% decline)
- 2010 earnings-per-share of $1.75 (19% increase)
Not only did Coca-Cola survive the Great Recession, it thrived. Coca-Cola grew earnings-per-share by 36% from 2007-2010. This shows the durability and strength of Coca-Cola’s business model.
The company’s dividend also appears very safe. We examine Coca-Cola’s dividend safety in the following video:
Valuation & Expected Returns
Coca-Cola expects adjusted earnings-per-share to be roughly flat this year despite a mid-single digit rise in organic revenue. At our initial estimate of $2.05 for this year, Coca-Cola trades for a price-to-earnings ratio of 21.9.
This is a premium of approximately 22% from our fair value estimate of 18 times earnings, which takes into account the stock’s historical valuations as well as future growth estimates.
While the stock is still overvalued in our view, it has come well off of the highs of recent years, when it traded in the 25+ area at times. Should the stock revert to our fair value estimate of 18 times earnings, it would introduce a 4% headwind to total annual returns.
Putting all of this together, we expect total annual returns of 5% to 6%, consisting of the 3.5% dividend yield, 6% earnings growth and a 4% headwind from the valuation.
Coca-Cola has made great strides repositioning its portfolio to meet changing consumer tastes. It has built a large portfolio of juices and teas, to cater to a more health-conscious consumer.
There is more work to be done to diversify away from sparkling beverages, and we see much-improved growth prospects beginning in 2020.
We continue to rate the stock a hold given its valuation, but we very much like Coca-Cola’s dividend as well as its improved growth outlook. We recommend investors wait for a better entry price before initiating a position.